Hedging vs. asymmetric hedging

 

Due to the large viewership of the blog post titled A short explanation on J.P. Morgan’s Derivatives Loss, I have decided to delve a little deeper and explain the difference between hedging and a strange phrase dubbed asymmetric hedging.

Jamie Dimon, CEO of J.P. Morgan Chase Corp., has attributed the recent massive losses due to asymmetric hedges the firm took. These losses were revealed in advance and ahead of the Q1 earnings report. What is interesting is the manner that the CEO described the loss, calling it a hedge gone wrong.

Now, to reiterate, to hedge means, to offset. An example would be to go long in an interest rate swap contract, in which J.P. Morgan pays a fixed rate of 500 basis points + spread between a AAA corporate bond and the 10 year Treasury security and receives 500 basis points + LIBOR. The transaction is settled quarterly and netted. This means that if at the settlement date, LIBOR is higher than the 10-year spread, J.P. Morgan, receives the interest difference between the two. This discrepancy is usually based on historical returns and current market fluctuations. In this case, the cash flows usually cancel each other out.

Now, in an asymmetric hedge, an example would be as follows: J.P Morgan would agree on a swap that includes paying 500 basis points + LIBOR and receives 500 basis points + the return on a thinly traded security or index. Now, in this case, the probability of small netted returns and cash flow netting is smaller, than in the previous example.

If for example, the thinly traded index fell 40% at the settlement date, J.P. Morgan would not only pay its cash flow, but the difference in the index between the two dates as well. It would have to book a massive loss for doing so.

That is an “asymmetric” hedge. Using leverage compounds the loss, and offsetting the position can also be very costly if the ongoing fundamentals for the swap is negative for J.P. Morgan.

The example doesn’t even resemble a classic hedge, but rather a speculative position. Even if J.P. claims that is making a market and offsets the position with its client through the hedge, seeking asymmetry is more something a hedge funds would do.

Fraud as the final step in a credit boom

 

There has been great many discussions about introducing new legislature concerning the overhaul of the financial industry. There has been calls for Glass-Stegall to be re-introduced. The Dodd-Frank overhaul act of 2010 is a massive 800 page juggernaut aimed against the “egregious” acts committed by Wall Street during the latest  recession. But, do laws really help against fraudulent behavior or are there deeper roots regarding this problem?

During the boom faze of the credit cycle, prices of factors of production and capital goods rise in value, the stock market rises and there is a sense of general euphoria. Companies are willing to go into debt to finance and expand entrepreneurial projects. They are romanced by the banking sector and the cheap funds that are all of a sudden granted to businessmen almost at no cost. Profits soar, and the balance sheets of companies have never looked stronger.

Assets are inflated in value, along with revenues. Projections based on current sales and expenses are prolonged into the future with expected double digit YOY growth. Companies in this period don’t really run high capital buffers to protect them in case of a sudden fall in ongoing revenue. They rarely engage in any accounting for reserve losses on their accounts receivables and a hectic schedule of ever increasing demand reduces their inventory amounts. The demand can be so excessive, that companies frequently neglect the qualitative value of there assets, as the only goal is to satisfy the voracious appetite of the consumers at large.

However, the fairytale economy built on money creation is an illusion, and soon companies will find themselves in trouble. The first thing that comes about is a cry for more liquidity; that is, the business community starts holding a grudge against the government due a “note shortage”, a situation where there isn’t enough funds in the economy for completing there projects of longer durations. Businesses are frightened due to rising interest rates and higher costs of going into debt or rolling over their current debts. Funding becomes an issue.

The only way for businesses to appear in good health is to engage in deceptive accounting or sometimes go so far and engage in embezzlement and fraud. Companies, which are first effected try to get rid of poor performing assets. But, instead of selling them, they usually engage in complicated repo transactions, where they try to ”window dress” their current financial mess.

(This closely resembles the situation and fraud perpetrated by Olympus in Japan. They tried to hide losses for over a decade in an ingenious scheme that finally unraveled a couple months back. For an accounting description of what happened read this post by an independent CPA from San Francisco located on retheauditors.com.)

But the window dressing and repo shams can last only for so long. The company will eventually run into problems paying back their vendors. They again decide to engage in aggressive accounting techniques using vendor financing. The troubled firm will sell their account payables for note payables. The cash injection will be recorded on the cash flow from operations (under IFRS) and when the note comes due, they may resort to booking it on the financing portion of the cash flow to make it appear that the firm is on steady grounds when its core business is concerned.

Fraud, in this context was generated not by an evil ambition of the businessman, but by a desperate attempt to stay afloat. That is usually what happens in a boom period. I am not vindicating this behavior, just stating the catalyst that brought such dubious behavior.

In a “normal” economy, these things happen as well, but are more profound during the end of the boom faze. Some other ways to manipulate earnings or financial statements is to: book revenue without shipping the product (bill and hold), booking a revenue when accrual accounting doesn’t allow it, lowering contra accounts to artificially prop up assets, capitalizing an expense when conditions are not made for it to be capitalized, engaging in aggressive securitizations, manipulating the life cycle of an asset, booking future profits, lowering the carry of defined pension benefit plans, using an asset as an operating lease instead of properly booking it as a finance lease etc.

The politics of employment

 

It is really sad that in todays world, one would get a job not because of his/her merit, but because of politics. This next article from business.hr really makes me sick:

“Minister of Environmental Protection and Nature Mirela Holy, in a written request addressed to the President of Railways Holding Renu Valcic tried to save one secretary from being fired reports HRT Broadcasting.

The written request in the first sentence emphasizes that the  the secretary is the wife of  a party colleague, but the CEO of Railways Holding Valcic rejected this request. Holy says that it is not a political intervention, but it is a recommendation for a humane attitude toward an employee of the Railways, the reports of HRT.  I appealed. I sent an official request from the mail, but mail from the party to a party colleague, "said the show 'Open'.”

Not a political endorsement? Humane attitude? This is one of many real life situations in which individuals wishing to resume a status quo situation are left begging to the government to save their rightfully earned workplace.

Insomuch, I wouldn’t be surprised if this individual earned twice as much as she would have earned in an unsubsidized industry subject to the laws of supply and demand for wages.